<<

. 30
( 208 .)



>>

the company focused on increasing the availability of its products through expanded use
of vending machines. In Mexico sponsorship of basketball was used to boost consump-
tion of Sprite. The challenge for investors and ¬nancial statement users is to assess
whether these marketing initiatives and brand extensions are likely to be successful in
creating value for Coca-Cola.
135
Asset Analysis




4-9 Part 2 Business Analysis and Valuation Tools




EXAMPLE: DEFERRED TAX ASSETS. Tax laws in the U.S. and many other coun-
tries permit ¬rms with tax operating losses to carry them forward to future periods when
they can be offset against positive earnings. These carryforwards potentially provide fu-
ture economic bene¬ts in the form of reduced future tax obligations. In 1998, for exam-
ple, Amazon.com, the Internet retailer of books, music, and video products, had
generated operating losses of $207 million, equivalent to $73.1 million of future tax sav-
ings since its inception. These “tax loss carryforwards” provided potential future eco-
nomic bene¬ts for Amazon.com. Of course, the carryforwards are only valuable if
Amazon.com actually earns future pro¬ts. The company reported that these loss carry-
forwards begin to expire in 2011.
How should ¬nancial reports record the operating loss carryforwards for Ama-
zon.com? Should they be reported as an asset in the balance sheet? If so, what is their
value given the likelihood that they may never be used if the ¬rm continues to show
losses? Under SFAS 109, U.S. ¬rms are required to show a deferred tax asset for the
value of operating loss carryforwards, net of a valuation allowance for the portion of the
asset that is unlikely to be realized. The FASB stated that deferred tax assets with more
than a 50 percent probability of being unrealized should be included in the valuation
allowance. This approach is similar to the valuation of accounts or notes receivable.
Receivables are shown at their gross value, net of an allowance for bad debts.
Deferred tax assets can also arise if tax reporting realizes income prior to ¬nancial
reporting. For example, prepaid revenues are often recognized for tax purposes prior to
¬nancial reporting recognition. Warranty expenses are accrued for ¬nancial reporting
purposes but are recognized when an obligation is incurred for tax purposes. As a result
of these temporary differences between taxable and reported income, taxes can be paid
prior to recognition of earnings in ¬nancial statements. The matching principle requires
the creation of an accrual to recognize this prepayment. SFAS 109 rules for recording
these prepayments are similar to those used to report operating loss carryforwards. A de-
ferred tax asset is created and a valuation allowance is set up to record the portion of the
asset that is unlikely to be realized.
Financial reporting for deferred tax assets provides management with an opportunity
to exercise judgment in estimating the valuation allowance. The basis for this estimate
is management forecasts of whether the ¬rm is likely to earn future pro¬ts and, if so,
whether they are suf¬cient to take full advantage of operating loss carryforwards and tax
prepayments. Recent research ¬nds little evidence that managers use this judgment to
manage earnings.2
Amazon.com reported that it has $12.8 million of deferred tax bene¬ts due to tempo-
rary differences between tax and ¬nancial reporting methods of recognizing income.
Combined with its $73.1 million of operating loss carryforwards, this amounted to an
$85.9 million gross deferred tax asset. The challenge for ¬nancial reporting was to esti-
mate what portion of this asset was actually likely to be realizable. The company had
never earned a pro¬t. Since 1996 its operating performance had actually deteriorated,
with losses of $6.2 million in 1996, $31.0 million in 1997, and $124.5 million in 1998.
Further, as of March 19, 1999, ¬nancial analysts did not anticipate the company to report
136 Asset Analysis




4-10
Asset Analysis




a pro¬t in either 1999 or 2000. Forecasts for these years are for losses of $400 million
and $140 million, respectively. On this basis it seemed unlikely that Amazon.com would
be able to take advantage of its deferred tax asset anytime soon.3 Consequently, the com-
pany reported that it included the full value of the deferred tax asset in the valuation al-
lowance, leaving a net book value of zero.


Key Analysis Questions
The above discussion illustrates three methods of reporting for outlays whose eco-
nomic bene¬ts are uncertain or dif¬cult to measure. The ¬rst, which requires im-
mediate expensing of the outlays, does not allow for any use of management
judgment in ¬nancial reporting. This method is commonly used for brand devel-
opment outlays and for R&D. The second method, which records an asset at the
amount of the outlay, provides for management judgment in subsequent periods
through amortization or write-downs. Examples include goodwill and ¬xed assets.
The third method requires the expected value of bene¬ts from an outlay to be re-
corded, requiring considerable management judgment. Examples include receiv-
ables and deferred tax assets. These three methods give rise to the following
challenges and questions for ¬nancial analysts:
• Which assets reported on the balance sheet are most difficult to measure and
value? Assets with liquid markets, such as marketable securities, are relative-
ly easy to value, whereas unique or firm-specific assets, such as goodwill and
brands, are most challenging. What is the basis for valuing these types of as-
sets? What assumptions have been made for financial reporting? For ex-
ample, what are the amortization lives of these assets, and what are
management™s estimates of allowances?
• How do any assumptions or estimates made by management in valuing assets
compare with assumptions in prior years? Has there been a change in as-
sumed goodwill lives? Is the current receivable or deferred tax asset allow-
ance as a percentage of the gross asset very different from prior years? What
factors might explain any changes? Has the firm made changes to its business
strategy or its operating policies? Has there been a change in the outlook for
the industry or the economy as a whole?
• How do management™s assumptions for valuing assets compare to those
made by competitors? Once again, if there are any differences, what are the
potential explanations? Do the firms have different business strategies? Do
they operate in different geographic regions? Does management have differ-
ent incentives to manage earnings?
• Does management have a history of over- or underestimating the value of dif-
ficult-to-value assets? For example, does it consistently sell these types of as-
sets at a loss or at a gain?
137
Asset Analysis




4-11 Part 2 Business Analysis and Valuation Tools




• What key assets are not reported on the balance sheet because of measure-
ment difficulties or uncertainties? These include brands, R&D, and other in-
tangibles. How does the firm appear to be managing these assets? Does
management discuss its strategy for preserving, enhancing, and leveraging
these assets? What indicators does the firm look at to evaluate how well it has
managed these assets?



Challenge Three: Changes in Future Economic Benefits
The ¬nal challenge in recording assets is how to re¬‚ect changes in their values over time.
What types of assets, if any, should be marked up or down to their fair values? Below we
discuss this question for changes in values of operating assets, ¬nancial instruments, and
foreign exchange rate ¬‚uctuations.

EXAMPLE: CHANGES IN VALUES OF OPERATING ASSETS. Changes in operat-
ing asset values are re¬‚ected in ¬nancial statements in a variety of ways. For example,
changes in receivable values are re¬‚ected in bad debt allowances, changes in the value
of loan portfolios are re¬‚ected in loss reserves, revisions in asset lives and residual val-
ues are re¬‚ected in amortization estimates, and declines in inventory and long-term asset
values are re¬‚ected in write-downs.
Accounting standards in the U.S. do not permit the recognition of any increases in
operating asset values beyond their historical cost. However, as noted in Chapter 7, SFAS
121 requires operating assets whose value is impaired to be written down to their market
value, below cost. This approach is consistent with the conservatism principle. Of
course, the challenge in implementing this standard is that it is often dif¬cult to assess
whether an asset has been impaired and, if so, the amount of the loss. As a result, there
appears to be considerable management discretion in deciding when to recognize that an
asset has been impaired and how much to write it down. Questions can arise as to
whether ¬rms delay recording asset impairments or underestimate the effect of impair-
ments. Alternatively, some have questioned whether managers use impairment charges
to overzealously write down assets to improve future reported performance.
In some other parts of the world, management is permitted to value assets at their fair
values. U.K. and Australian standards, for example, permit managers to revalue ¬xed as-
sets and intangibles if they have appreciated in value. Thus, in its 1998 annual report,
News Corp, the Australian news and media company run by Rupert Murdoch, reported
that the intangible asset Publishing Rights, Titles, and Television Licenses was revalued
to its fair value. Fair values were estimated by “discounting the expected net in¬‚ow of
cash arising from their continued use or sale.” (See Footnote 1 of News Corp™s annual
report.) As a result, the ¬rm showed intangible assets that cost A$7,283 million at a fair
value of A$12,030 million.
138 Asset Analysis




4-12
Asset Analysis




By permitting ¬rms to revalue assets, U.K. and Australian standards potentially per-
mit managers to communicate their estimates of the value of the ¬rm™s key assets to in-
vestors. However, they also provide increased opportunity for asset overstatements.4

EXAMPLE: CHANGES IN FINANCIAL INSTRUMENT VALUES. Many ¬nancial as-
sets are traded in a liquid capital market, permitting relatively objective values to be ob-
tained. For debt securities, even though markets may not be very deep or liquid, ¬nancial
valuation models enable relatively reliable estimates of value to be made. Finance theory
posits that ¬rms (or individuals) can typically buy or sell ¬nancial instruments in ¬nan-
cial markets at the current market price, provided they are perceived to have the same
information on the instruments™ values as other investors. As a result, since fair values
can be obtained at low cost, can be independently veri¬ed, and are more relevant to ¬-
nancial statement users than acquisition cost, a good argument can be made for marking
assets up or down to market prices.
Of course, if the owner of ¬nancial instruments exercises control over the other com-
pany, the owner is unlikely to be able to transact at market prices. Attempts to sell the
instruments will be interpreted by other investors as indicating that the seller considers
it a good time to sell, reducing the price. This suggests that marking such assets to mar-
ket is less appropriate.
Figure 4-2 summarizes the valuation effects of accounting for changes in values of
¬nancial instruments. It shows that the reporting effects depend primarily on the owner™s
motives.
U.S. accounting rules do not permit instruments to be recorded at their fair values if
they are owned for control reasons. Instead, the investment is recorded using either the
equity method or the consolidation approach. The equity method is used when a ¬rm
owns 20“50 percent of another company™s stock and is considered to have partial but not
full control of the other company (called an associated company). The investment is then
valued at its original cost plus the owner™s share of the associated company™s accumu-
lated changes in retained earnings since the investment was acquired. For investments in
excess of 50 percent, the owner is considered to have full control over the subsidiary
company. The acquirer then consolidates the assets of the subsidiary with its own assets.
Two methods of consolidation are used. If the subsidiary is purchased in a cash transac-
tion, purchase accounting is used. The assets of the subsidiary are then included in the
owner™s balance sheet at their fair values at acquisition and subsequently amortized. Any
difference between the purchase price and the fair value of net tangible assets is recorded
as goodwill and amortized over its useful life up to a maximum of forty years. If the sub-
sidiary is acquired for stock, the pooling of interest method is used to record the acqui-
sition. The assets of the subsidiary are then included in the owner™s balance sheet at their
original book values. No goodwill is recognized.
If the owner of ¬nancial instruments does not exercise control over the other com-
pany, accountants are more inclined to value the instruments at their fair market values.
For example, if the purpose of ownership is to hedge changes in the fair value of another
139
Asset Analysis




4-13 Part 2 Business Analysis and Valuation Tools




Figure 4-2 Valuation of Financial Instruments

Q: What is the motivation for ownership of
the ¬nancial instruments?




A: Used as a way to exer- A: Short-term alternative to A: Used as part of strategy
cise some level of control holding cash. to hedge fair values of
over another company. If so, 1. Intend to sell or make assets or liabilities, or to
what is the level of control? available for sale. hedge uncertain future cash
Valuation Method: Fair ¬‚ows.
value Valuation Method: Fair
2. Intend to hold to maturity. value
Valuation Method: Cost




A: Own between 20% and A: Own more than 50% of
50% of the other company. the other company.
Valuation Method: Equity Valuation Methods:
method: Investment shown Purchase accounting: Tangi-
at initial cost plus share of ble assets recorded at fair
accumulated changes in values at acquisition, and
associated company™s then depreciated. Goodwill
retained earnings. recorded at difference
between purchase price and
fair value of net assets, and
then amortized.
Pooling: All assets recorded
at book values at acquisi-
tion. No goodwill.



item or to hedge ¬‚uctuations in expected future cash in¬‚ows or out¬‚ows, the instrument
is reported at fair value. If a ¬rm holds an instrument as a store of cash and either intends
to sell it or has it available for sale, it is reported at fair value. Only if management
expects that an instrument will be held to maturity is it reported at historical cost.

EXAMPLE: CHANGES IN VALUES OF FOREIGN SUBSIDIARIES. Many companies

<<

. 30
( 208 .)



>>